My opinion piece today is on the multifarious uses for income contingent loans. Full text over the fold.

Putting a HECS on Life, Australian Financial Review, 6 May 2008

With budget season upon us, stand ready for interest group after interest group to picture the government as kind old Uncle Oz. He gives to so many, they will argue, so why not to us? Surely a few more dollars to our special cause couldn’t hurt? (Cue heartrending description of flashy infrastructure project, photogenic industry, or working family.)

The problem with this notion is that most kindly uncles don’t come knocking on the door on 31 October, asking for a tax bill to pay for next year’s goodies. So rather than focusing on government’s role in distributing largesse, some economists – chief among them Australian National University economist Bruce Chapman – have argued that we should think of government as a piggybank, helping us to manage risk and uncertainty over our lives.

Chapman’s leading contribution to policy has been the Higher Education Contribution Scheme. Adopted in Australia in 1989, HECS requires students to pay back a portion of their university tuition when their earnings pass a given threshold. If earnings drop below the threshold, no repayment is required. By requiring students to contribute to the cost of their education, HECS recognises the substantial private benefit to attending university. Its â€˜study now, pay later’ approach helps smooth income over the lifecycle, and ensures that the poor are not prevented from enrolling.

Since 1989, HECS has been taken up by Ethiopia, New Zealand, Thailand, and the United Kingdom. Having had more influence over worldwide policy than any other Australian economist of his generation, one might have thought that Chapman would retire to the ivory towers. But instead he has set about applying the same idea – loans instead of grants – to a wide variety of policies. Here are just a few.

HECS for Drought Relief: When heavy rains reduce profits in beachside resorts, policymakers typically do nothing. Yet when drought hurts farmers, the government is ready with a handout. Politically, it is unlikely that we could scrap drought assistance programs. But a better way to deliver it would be through income contingent loans, repayable in good times. So long as loans are targeted towards farms with viable long-term prospects, they would help reduce volatility for farmers, while requiring those who are able to repay the loans to do so.

HECS for Sportspeople: For those lucky enough to win a place, the Australian Institute of Sport offers elite athletes one of the best training programs in the world. Partly as a result, many AIS graduates go on to perform at the elite levels of their sport. Yet AIS graduates with seven-figure earnings – among them Lleyton Hewitt, Mark Viduka and Jelena Dokic – are not required to pay back a cent of the cost of their training. If a HECS-style loans scheme was put in place for elite athletes, the size of the AIS could be significantly increased with no additional cost to the taxpayer.

HECS for Parents: Once upon a time, assistance to families went only to the poor. Over the last decade, changes in the Baby Bonus, Family Tax Benefits and Child Care Benefits have seen family payments grow steadily more generous for the middle and top of the income distribution. Yet Australia remains one of the few developed countries that without government-funded paid maternity leave, prompting calls for another family payment to be introduced. One answer would be for government to offer paid maternity leave through an income contingent loan – thereby providing families with more money at the time of life when they need it most, without unfairly redistributing resources from poor singles to rich families.

HECS for Fine Defaulters: When it comes to collecting fines, governments are the world’s worst debt collectors. One study estimated that the Victorian government managed to collect just 44 percent of court-imposed fines. Because we are reluctant to send non-payers to jail, and because enforcement often costs more than the fine itself, the justice system is left impotent in the face of rampant non-payment. In the same way as the taxation system is used to deduct Child Support payments from the incomes of non-custodial parents, it could be used to ensure that recalcitrant criminals paid their debts.

Once you start thinking about government as piggybank, the world starts to look very different. (You may find yourself asking questions like â€˜if artists want more money, why not replace grants with loans?’) Fundamentally, Chapman’s simple idea accords with the Australian ideal of a fair go: helping people in their time of need, but also expecting them to give a little back when times are good. For a government with more ideas than dollars, expanding income contingent loans might be just the solution.

Andrew Leigh is an economist in the Research School of Social Sciences at the Australian National University.

8 Responses to Why give when you can lend?

I understand the logic of applying income-contingent loans to drought relief, training of elite sportspeople and, even, paid maternity leave. To some extent, all of those activities are voluntary (in the case of drought relief, the voluntary bit is choosing to stay on the farm) and there is a reasonable expectation that one day the money will be paid back.

I’m not so sure about fine-defaulting though. Wouldn’t you be creating a significant moral hazard for low-income people to go around incurring as many fines as they feel like, if they think they are likely not to have to pay them back? And to the extent that fines fall more heavily on the lower-income section of the population (I’m not sure whether they do or not), then your risk of future non-repayment could be considerable.

I must admit I’m always a bit uncomfortable with the concept of applying the income-contingent loan solution to people with relatively low earning capacity. This is because you may be creating a significant disincentive to them earning as much as they can in future, because doing so would involve paying back the debt. So, for example, you could end up locking a lot of lower-skilled women into part-time work as a result of them having opted to take the maternity leave loan.

Applying income-contingent loan solutions only discourages people from striving to make more money in the same way that income tax does. Not much.

As long as the “ramp up” rate isn’t too high, you’re OK.

In fact, I think, in this sense you’ve put your finger on the problem with the modern HECS for students system.

“In my day” (he says with wavering, mock-old-persons voice) the rate of income at which you started paying HECS was quite high, and the percentage of your income it took was quite low. The complaint was that some 60-70% of people never ended up paying back their debt.

So they lowered the level at which you started paying it back, and raised the percentage of your income you paid.

But I say “let them never pay it back”. Basically then, the majority of people get a government subsidised tertiary education and only the top 20-30% of earners pay for their entire university time. Doesn’t that sound about right? I think we should go back to those kind of arrangements. Sounds fair to me.

So, if you train as an accountant or a lawyer, and make big money out of it, likelihood is you’ll pay the society back for giving you the leg-up to a privileged position. If you train as a nurse of teacher, you’ll probably never pay it back – but neither should you, on those wages.

AND if you train as a nurse or a teacher and happen to make it big on the stock market or through some other means, you end up paying back the cost of your education, because you happened to make the money to do so.

First, a pedantic note: “Once upon a time, assistance to families went only to the poor.”

Hmm, appropriately enough this is how fairy tales traditionally begin. In reality, I donâ€™t think there has ever been a time in Australian history when assistance to families went only to the poor. For a broad history look at http://www.aifs.gov.au/institute/pubs/fm2001/fm60/pw.pdf , although this does not take account of changes since 2001. In essence, family cash benefits were universal from the 1940s until 1987, and tax support for families favoured higher income households until 1974. The maternity allowance introduced in 1912 was also universal, and not abolished until 1978 (when its real value was very low).

It is true that the Australian system has always been among the most targeted of all OECD countries, and while changes since 2000 have reduced the extent of targeting, it still remains among the most targeted in the OECD â€“ the concentration coefficient for Australian family cash benefits (i.e. the Gini coefficient but with households ranked by disposable income) around 2005 was lower than for all but about 5 countries. And among these you also need to take account of tax support for families e.g. the US has the most progressive family cash benefits but it also has much larger universal support through the tax system.

Now this doesnâ€™t mean that the current system shouldnâ€™t be reformed, but I think we should be careful about getting history right!

Second, on the policy side there appears to me to be a significant difference between repaying maternity payments and repaying HECS or AIS support. While people choose to do these things â€“ have children, go to university, try to become a successful sportsman â€“ the result of successful completion of the second two options is a significant increase in future cash income. The usual result of the first choice for mothers is a significant reduction in lifetime cash income.

â€œHECS for Drought Reliefâ€: I see a couple of problems. The first is that the repayment period of such loans would usually need to very short (ie over the few good seasons in between the few bad ones). This means they would have to be levied at very high rates â€“ as a â€˜tax add onâ€™ this would result in very high (and politically sensitive) marginal tax rates. Secondly, given the average age of farmers, it is highly unlikely that for many, again unless the repayment time was very short, that they would continue to earn over a long enough period â€“ rather they would just sell the farm and retire with the outstanding debt. The alternative is to suggest that the loans could be structured against assets rather than income â€“ say recoverable from the estate, while I think this is a great idea, given the past track record of Australia with death duties I do not think it will work. The cynic in me also suggests that in most cases farmers have a good track record of not having much â€˜incomeâ€™, at least for tax purposes, even when things go well. More generally as a principle this type of drought relief should only be provided after assessment of the ongoing viability of a property â€“ I am wondering whether making it a contingent loan would tend to reduce the prudential considerations. Surely self insurance through Farm Management Deposits may be the better path.

â€œHECS for Sportspeopleâ€: No problems with the concept â€“ but do you fund this just from their sports earnings â€“ or from all their earnings (even if they turn out to be a totally dud sportsperson â€“ or as so often happens they cop some devastating injury which stops them both from participating in their sport and involves them in ongoing costs), if they also study at Uni do they have to pay their sports loan back simultaneously with their HECS â€“ even when their earnings capacity is driven by their education and not their sports? Also the premise that most sports people going through AIS make lots of money is largely mistaken. I also wonder what it would do to the mix of programs offered by the AIS.

â€œHECS for Parents:â€ Andrew as you will discover in coming years the cost of children is not just in the short term so there is a real question about when you would start levying the repayments. Also is there a failure of the private market â€“ unlike students where there is massive uncertainty about future earning capacity and proven credit worthiness surely most prospective parents have much more certainty â€“ as well as some assets they can use. Also if people cannot afford to have children should temptation be put in their way?

â€œHECS for Fine Defaultersâ€: The idea of punishment is to link it to the event for which the person is being punished â€“ why make it contingent upon their income â€“ if they copped a fine just garnishee it from whatever income they have (social security or anything else). (The more important question is when will fines be made relative to the actual income of the person rather than a flat monetary amount so that punishment impacts equally on people regardless of their resources.)

â€œHECS for Studentsâ€ Why not just rely upon a progressive income tax system, why assume that the higher earnings of a person occurred as a result of their further education, rather than despite it, why differentiate between the cost of tertiary education and year 12 and TAFE apprenticeship training, why not make apprentices pay fees to their employers (as they did once upon a time) and pay a HECS to repay these? Again there is a need to consider the distortions that HECS introduces â€“ with various universities hawking PhD courses to the retired on the basis they will never have to repay the cost.

Contingent loans are an example of what I called tagged money. That is we add some extra information onto some money that affects how the money is used. I am grateful to you for pointing out these various ideas and schemes as one of the criticisms I receive is – ‘if this is such a good idea why aren’t people doing it’. My answer has been – ‘the technology to make this feasible only became available within the last 5 years ago and so the only schemes were things like compulsory superannuation’. You have given me another whole set of examples where it has been possible to do it with old technologies by applying many constraints and by using the existing taxation system to implement them.

Tagged money gives a way to do contingent loans efficiently without the tax office and in such a way that the outcomes can be precisely measured.

For example to implement HECS we do not need to involve the tax office and we can have a whole range of rules to cater for different characteristics of each individual. We can also enforce compliance in various ways depending on the characteristics of the individual. Eg. if you have outstanding HECS then you may not be able to participate in other designated schemes if you have not paid your HECS.

This is achievable because the information about each individual receiving the money is attached to the money (anonymously).

For those who are concerned about the effectiveness of such schemes we can measure how each individual behaves and report it in anonymous ways so that we can see if the scheme is having the desired result – and you can do it precisely and in “real time”. For example Backroom girl would be able to find out if there was indeed a moral hazard on loans for fine defaulters. (If there is then the rules of the loan can be changed to overcome the problem. This is easy to do because each person has an individual contract)

While all this sounds incredibly complex in practice it is amazingly simple because we have machines interpreting and acting on rules and the rules are applied at the individual level. We do not need people interpreting and trying to understand how to apply rules when say filling out their tax returns.

The thinking goes into the formulation of the contracts and the rules on the money and in interpreting the outcomes. In effect these sorts of systems will evolve with an initial set of rules and output measures which will in turn feedback to rule modification and with a bit of thought even that may be automated.

The implementation of tagged money opens new frontiers for economists and will give them many job opportunities 🙂

BTW if anyone from the Department of Education is reading this then perhaps they can contact me and we can together devise a system that will remove HECS from the tax system. The cost of operating the system will be a lot less than the current cost and it can be made more flexible and be able to be integrated easily with the other schemes that assist people with their education and training (why shouldn’t we have contingent loans for preschool education?) – and it will be possible to measure outcomes precisely.